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Tax Considerations for Start-Ups (Part 2)

June 13, 2016

In the excitement of raising money from investors then launching, a new start-up business ,many founders and stakeholders are focused on refining the product / service offering, acquiring customers, making sales and making the business profitable.

But founders should be both mindful and vigilant about meeting all their tax liabilities. Not doing so could result in extremely unpleasant consequences, including stiff fines from federal, state and local tax authorities.

Here’s an overview of the business owner’s role / responsibility, and a list of tax-related issues that should be considered by savvy founders, ideally with the help of a qualified CPA.

EMPLOYEE CLASSIFICATION

Screen Shot 2016-06-13 at 10.38.17 AMIncorrectly classifying employees within start-ups can turn into a big problem! Classifying employees as independent contractors to reduce or eliminate withholding obligations may be disputed by tax authorities.

According to the IRS you must withhold income taxes, withhold and pay Social Security and Medicare Taxes, and pay unemployment tax on wages paid to an employee.You do not generally have to withhold or pay any taxes on payments made to independent contractors. More detailed information is available from the IRS here.

Be aware that classifying a worker as an independent contractor does not guarantee that the IRS and other taxing authorities will accept this classification. And taxing authorities are increasingly challenging these classifications.

Therefore, it is important for a startup company to go through a thorough analysis of whether a worker should be classified as an employee as opposed to an independent contractor.

In general terms anyone who dedicates their full time and attention to a job, is under the control of and provides services, more or less, exclusively for a company – is going to be considered as an employee, no matter what they are called.

If the government is successful in reclassifying a worker as an employee, the employer can be subject to penalties for failing to withhold and remit taxes, including during the time it classified the worker as an independent contractor.

This is generally discovered when a contractor files for unemployment compensation after leaving a job, and the government can’t find a record of their employment.

WITHHOLDING EMPLOYMENT TAXES

Screen Shot 2016-06-13 at 10.39.58 AMEmployment tax withholding applies to most employees. When applicable, you must withhold both federal and state employment taxes. There are requirements, risks and considerations for each.

At the federal level, an employer generally must withhold federal income tax from its employees’ wages. The withholding also includes the employee portion of Social Security and Medicare taxes.

In addition, there is Federal Unemployment Tax (FUTA), which is reported separately from federal income tax and Social Security and Medicare taxes. The FUTA responsibility is solely that of the employer. The employees do not pay this tax themselves or have it withheld from their pay.

STATE EMPLOYMENT TAX: WITHHOLDING CONSIDERATIONS.

State employment tax withholdings depends on business activity within a state. Employing workers in remote locations can complicate your tax picture!

Thanks to technology, start-up employees rarely remain confined within the borders of one state. When a company starts sending employees into other states to perform services or employs residents of other states, the company may be required to withhold employment tax for those states related to those employees.

As with sales tax, a state cannot require a company to withhold employment tax unless the company has established nexus. When it comes to employment tax, nexus can be established as the result of:

A business location within a state.
An employee’s regular performance of services within a state.

Once nexus is established, most states require withholding on employee wages that are sourced to that state. Further, once established, nexus continues for the full calendar year at issue.

It is difficult, if not impossible, to reduce this exposure. In many states, there is no defined minimum level of contact with the State, below which withholding would be unnecessary. In those states, having an employee work for even as little as one day can trigger a withholding responsibility on the part of the employer.

Other states use different methods to determine if an employer has withholding tax responsibility for its employees. These thresholds can be based on the number of days an employee visits a state or the amount of an employee’s wage income resulting from the services within that state.

WORKERS’ COMPENSATION

Worker’s compensation is a state mandated insurance program that provides cash benefits i.e. for wage replacement and/or medical care for workers who are injured or become ill as a direct result of their job. It is sometimes overlooked by newly founded companies. Failure to secure coverage can lead to civil as well as criminal penalties, which can carry very large fines.

This material has been prepared for general informational and educational purposes only and is not intended, and should not be relied upon, as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

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